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That's Steam Not Smoke On Wall Street

August 15, 1993

Finance

THAT'S STEAM--NOT SMOKE--ON WALL STREET

Stock market investors are sweating, and it's not just the weather. What's frightening them is that the Dow Jones industrial average is near its all-time high of 3568, the dividend yield on the Standard & Poor's 500-stock index has dropped to a dangerously low 2.8%, and some market gurus are comparing today's market to August, 1987, when stocks peaked and then began a tailspin that ended in the October crash.

Forget it. Relax and enjoy the summer rally. Sure, the stock market has some problems--especially the lackluster economic recovery--but the bull is not about to give way to the bear. The critical elements that helped push the market up more than 50% in less than three years are still at work. The combination of low interest rates, improved corporate earnings, and a torrent of cash from individual investors into mutual funds is a surefire recipe for higher stock prices.

ROLLING IN. In the first half of the year, investors plunked a huge $60 billion into equity funds, vs. $78 billion for all of 1992. And the pace is not letting up. Fund sales usually slacken in the summer months, but July sales should weigh in at about $8.2 billion, according to Robert Adler of AMG Data Services. That's an increase of 25% over July, 1992.

That money will keep rolling in as long as interest rates stay down--and they probably will. Despite rumblings about tighter money from the Federal Reserve and fears of higher food prices induced by the farm belt floods, inflation is a paper tiger. Wage gains are almost nonexistent, unemployment is sky high, and oil prices are tanking.

Still, the Wall Street wags are downbeat. In the latest poll of 130 newsletters by Investors Intelligence, only 38.9% were bullish, while 37.3% were bearish for the long term and 23.8% expected a short-term correction. But don't be cowed by the pros. That so few are bullish at a market high bodes well for stocks, says pollster Michael L. Burke. At the peak in 1987, he notes, 60% were bullish and only 20% bearish.

To many blue-chip investors, it probably doesn't feel like a bull market. Many of the stars of the last few years--such as Apple Computer, Merck, and Philip Morris--are getting mauled. And although the Dow has gained nearly 8% so far this year, the broader S&P 500 index is up only 3% (chart). "Equity investors are getting sticker shock, and it's making them unhappy," says John W. Ballen, who heads equity research at Massachusetts Financial Services, which runs $32 billion in mutual funds. "But this is the '90s. The kind of returns you saw in the '80s are gone."

The divergence between the 30 Dow stocks and the 500 S&P stocks also gnaws at some pros, since the broader S&P is a far better measure of the equity market. "The S&P 500 has basically gone nowhere since February," says David G. Shulman, investment strategist at Salomon Brothers Inc., who expects a market sell-off this quarter. "The Dow's sending the wrong signals."

PROFIT PRESSURE. But the two indexes have parted company before without disastrous results. Midway in 1992, the Dow was outpacing the S&P, but the two finished the year with near-identical results. That could happen again this year, though it would probably take a huge rally from the large-capitalization consumer growth stocks that dominate the S&P 500 and have been under profit pressure from price-conscious consumers.

But even if the S&P doesn't close the gap, it's not fatal for stocks. The Dow's strength is coming, in part, from cyclical, or economically sensitive, stocks such as AlliedSignal, Caterpillar, General Motors, and United Technologies. Since cyclical stocks have more influence on the Dow than on the S&P, all the divergence is telling investors is that the economy is looking up.

In fact, the long-term bullish case for stocks rests largely on an improving economy and better profits, since analysts believe interest rates have driven the market about as high as they can.So far, second-quarter operating profits for companies in the S&P 500 are up 16.8%. That's about 2.5 percentage points better than expected, says Ben Zacks of Zacks Investment Research, and because of it, analysts are ratcheting up forecasts for coming quarters."The worst of the economic news is behind us," declares Byron R. Wien, U.S. investment strategist for Morgan Stanley & Co., who expects economic growth in the second half to accelerate to 3% from the first half's anemic 1%. That will help the profit picture.

PROFIT PROSPECTS. "The recovery in earnings, while not spectacular, will still be in the 11%-to-15% range," says Timothy G. Connors, who manages $600 million for CoreStates Investment Advisers. Based on the past 12 months' earnings, the price-to-earnings ratio of the S&P is an uncomfortably high 23. Looking forward, says Connors, it's a far more moderate 16. "The long-term average is only 14, and that incorporates a lot of periods when interest rates and inflation were a lot higher than they are now."

Improving profits make many stocks--especially the beaten-up technology issues--look cheap. Melissa R. Brown, director of quantitative analysis at Prudential Securities Inc., says Advanced Micro Devices, Compaq Computer, Exar, Hewlett-Packard, and Ray-theon sell at less than 13 times the earnings projected for the next 12 months.

The profit prospects may even get a further lift from the currency turmoil in Europe, which paves the way for interest rates to come down and give a boost to the recession-racked continental economies. That could mean better earnings for the companies in the S&P 500, which get about 40% of their earnings from overseas, even though a stronger dollar might cut into some of those profits. "We're advising people to buy U.S. companies that can do well abroad," says William E. Dodge, investment strategist at Dean Witter Reynolds Inc. Those companies include General Electric,Fluor, Foster Wheeler, and Ingersoll-Rand.

Dodge, who has been bullish, thinks the market could deliver another 6%-to-7% in total return by yearend. And the evidence suggests he may right. The only ones who will be sweating will be the gurus who have been telling their customers to get out of stocks.Jeffrey M. Laderman in New York